Covered Call trades are a good indicator of bullish or bearish sentiment,

Long Call trades are a good indicator of bullish strength or weakness, and

Long Straddle trades have typically been a good indicator of whether most traders are surprised by current stock prices, thus a good indicator of stock prices being overextended.

When a Bull market is in progress, certain expiring Long Call option trades can be analyzed to determine whether the bullishness is weak or if it is strong. The Long Call/Married Put Index has proven to be a good measure of bullish strength. Anytime it is above zero, it is likely that bullish strength is present among most S&P 500 stocks. Currently there is clearly bullish strength.

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Lastly, any market can get overextended from time to time, whether it’s a Bull or a Bear. Stock prices can rise too fast to be unsustainable just as they can fall so quickly that traders are bound to step in and buy them.

The performance of certain Long Straddle option trades has a good history of showing when stocks have become so overextended that they are either due for a reversal of the recent trend or else due for a major breakout from a period of stagnation. Currently the S&P is clearly overextended. One can infer from the #LSSI that the current rally is likely going to lose strength. It does not imply that the rally will end, just that based on historical data, the recent trend cannot be expected to continue at its recent pace much longer.

It could mean a reversal is coming; It could mean a period of sideways consolidation; Or it could just mean a slowing of the uptrend; there is no way to know for sure.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to [email protected]